Question

Tool Manufacturing has an expected EBIT of $81,000 in perpetuity and a tax rate of 23 percent. The company has $142,000 in outstanding debt at an interest rate of 6.1 percent and its unlevered cost of capital is 12 percent.

  

What is the value of the company according to MM Proposition I with taxes? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Solution :-

Value of the Unlevered firm = EBIT( 1 - TAX RATE)/ COST OF EQUITY

= $81,000 ( 1 - 0.23 ) / 0.12

=$519,750

Value of the levered firm = value of the unlevered firm + debt tax shield

= $519,750 + 0.23 ( 142,000)

= $519,750 + $32,660

= $552,410.00

Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase its debt/equity ratio to maximize the value of the firm.

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